Single-asset CMBS bonds at risk

While Moody's Investors Service's new framework for rating domestic CMBS transactions that lack sufficient terrorism insurance coverage may imply the possibility of downgrades on triple-A bonds in single-asset transactions, market participants say that it will have limited impact on investors who deal with traditional conduit paper.

"What the [Moody's] report puts a lot of focus on are the large-loan deals," said Marc Peterson, CMBS manager at Principal Capital Real Estate Investment. "For the most part, the majority of CMBS is traditional conduit paper where you don't have exposure to any one big property so I don't think the market is going to be dramatically impacted except for those large-loan and single-asset deals or maybe some fusion deals. If you look at where large loan deals and single-asset transactions are trading today, they are probably two to 30 basis points back of where they were prior to 9/11. So the risk has already been reflected in how those deals were priced."

However, for investors with single-asset exposure whose charter requires a triple-A rating on bonds that they hold, a downgrade on this paper would be, as one analyst puts it, "horrendous."

Moody's has clearly stated that it is not considering downgrading existing deals in the next few months while the it is in the process of evaluating government and insurance industry responses to the availability and cost of terrorism insurance.

While some market participants have taken comfort in Moody's delay, some analysts have expressed doubt over whether single-borrower deal activity will resume at a healthy pace after it was stalled in anticipation of the release of the Moody's report.

Impact on new deals

Moody's made it clear in its report that the new framework will have the greatest impact on triple-A rating levels. This is because the firm believes that "the risk of default because of a terrorist attack may be Aaa risk for certain assets; may be viewed as a Aa risk for other assets; perhaps even an A risk for some properties; but is rarely if ever a Baa risk for any asset."

According to the rating agency, it is most concerned with the lack of terrorism insurance on single-asset deals backed by trophy properties; these transactions would receive the most severe changes to the number of bonds that would be given a triple-A rating. However, minimal credit adjustment will be seen on conduits backed by generic assets.

For single-asset transactions, the rating agency has assumed the worst case, which is the complete damage to property. Analysts said that in most instances some residual land value could remain even after total property destruction, so that in almost all transactions, Aaa proceeds (though considerably less) will still be available even without terrorism insurance coverage.

Darrell Wheeler, a CMBS strategist at Salomon Smith Barney, said that he is not surprised by the agency's response.

"Basically it is common sense. Before Sept. 11 a triple-A investor was protected for a terrorism event, but now what Moody's is saying is all you can count on is the land value," said Wheeler. "This rational but conservative approach should cause little problem for the majority of CMBS deals which are backed by multiple loans. But if we don't get more terrorism insurance availability and Moody's implements their report, we could see significant triple-A downgrades in the $30 billion in outstanding single-asset bonds."

Roger Lehman, a director at Merrill Lynch, said in a recent report that with the rating agency indicating that land value can range between 10% and 40% of the asset value, "this could mean a drastic reduction of triple-A proceeds on newly rated single-borrower deals."

Lehman added that Moody's is unclear as to how much credit it would give beyond land value. Further, the rating agency did not specify the amount of credit it will give for land value.

Ambiguities of the report

Merrill's Lehman also said that the pick-up in single-borrower activity that started in early February was halted in the weeks before the release of the Moody's report because of the uncertainty about the severity and timing of possible downgrades.

He said that it is uncertain whether or not trading activity will resume at a robust level, even after the release of Moody's report. Considering the framework's vagueness, Lehman says, he is not sure the release of the report leads to "a return of robust trading activity or narrow bid/offer spreads on single-borrower deals."

Some investors believe Moody's did not make it clear how the framework would affect existing transactions without sufficient insurance coverage.

"For most investors the first question that comes to mind is what is going to happen to existing deals," said Lipkee Lu, a CMBS portfolio manager from Deerfield Capital Management. "Basically Moody's is saying that they are going to wait and see whether Congress is going to take some action before they make any rating action. Having said that, we are looking forward to Moody's review to get a better understanding about how to look at this particular risk, which has some subjectivity to it."

Observers say that even though Moody's framework gives an idea of what assets would be most affected, it involves classifying properties as the most likely terrorism targets, which is somewhat subjective. It is unlike looking at loan-to-value ratios of collateral, for instance, where there is a definite number that could be agreed upon.

The larger picture

The uneconomic pricing and lack of terrorism insurance have had a greater impact on commercial real estate and mortgages over the past few weeks. The impact has been gradual, as borrowers that have mortgages expiring find the lenders that have traditionally provided loans greater than $50 million are withdrawing from the lending market.

In recent weeks, there have been several stories of lenders being unable to secure financing. But most recently the lack of financing caused a high profile suit between Simon Properties and its loan servicer GMAC, as Simon had renewed its policy with terrorism insurance excluded. The servicer has an obligation to protect the asset and thus found $100 million of coverage was available at a cost of $750,000 per year. But when the servicer obtained the policy on behalf of Simon, Simon obtained an order that prevented GMAC from paying the policy.

"We don't know yet if this first experience will be typical judicial response to what is likely a non-monetary default as the various mortgage documents may have stronger or even weaker insurance requirement terms", said Salomon's Wheeler, "But what is clear, is various market participants are going to be spending considerable resources fulfilling their obligations under the securitization documents".

Wheeler said that even if an owner can obtain terrorism insurance the costs are very high. Those high costs will be passed on to the underlying tenants at a time the economy is trying to recover. This is clearly an area that could have a negative impact on the economy and would benefit from immediate government intervention.

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